Passive universe made of more than just ETFs

Coutts uses exchange traded funds(ETFs) to blend active management with passive, preferring active where stockpicking can add value in regions such as Japan and Europe, and using passive vehicles primarily for efficient markets. However, index funds are generally preferred to ETFs for passive holdings owing to their lower charges and often, increased capacity. For example, the Royal London FTSE 350 Tracker Fund offers exposure to the wider UK market, large and mid caps, at just 15 basis points, compared with 40 basis points for a FTSE 100 ETF, explains Niamh Wylie, portfolio manager at Coutts, and regarding capacity, she says “given the size of our discretionary book, funds need to be at least £100m (€124m) in size for us to make an allocation”. She points to the example of the Royal London FTSE 350 Tracker Fund, which is £2.6bn in size.

“There is some competition entering the UK market offering lower cost ETFs, but these funds are still too small for us, at only £30-£50 million in size,” she explains.

A typical high risk Coutts portfolio will be 50 per cent invested in passive instruments, of which 10 per cent would be in ETFs, the other 40 per cent in traditional index funds. Allocations to passive vehicles in lower risk mandates are about 30 per cent as Coutts prefers to use active funds for its credit exposure.

“While flows into fixed income ETFs have increased this year, as a house we believe in using active managers in the credit and high yield space to unlock alpha potential,” says Ms Wylie. “Credit ETFs tend to underperform as it is an OTC market and this can impede liquidity, making it harder to invest heavy inflows on an index basis.”

Coutts has this year added to its holding in a gold ETP (exchange traded product), and also has a longer term buy and hold position in emerging markets ETFs. The house also owns some smart-beta ETFs such as State Street SPDR S&P Dividend Aristocrats – companies from the S&P 500 that have stable or rising dividends for 10 years, where the maximum per company or sector is capped at 5 per cent and 30 per cent respectively.

STOCK LENDING RISK

One concern about ETFs is their stock lending policies, particularly in larger markets where ETFs sometimes lend out 60 per cent of their stock. Jonathan Clatworthy, senior investment manager, Arbuthnot Private Bank, points out that synthetic ETFs had a bad press a year ago as investors did not understand credit risk, but investors equally may not appreciate stock lending risk.

He is looking at risk-backed diversification as an improvement on asset based diversification where under stress conditions asset correlations have been running to 1. A variety of different risk factors can be used to improve diversification and reduce tail risk, such as momentum, large and small cap bias, and liquidity.

Croci (Cash Return On Capital Invested, Deutsche Bank’s proprietary and trademarked methodology) funds are on the shortlist, as is Lyxor ETF MSCI World Risk Weighted fund based on higher volatility/lower index weighting. The fees for this are relatively high, however, at an AMC of 45bps, and a 3.5bps creation fee, totalling a total expense ratio (TER) of around 65bps once rebalancing costs are taken into account.

A further advantage of smart ETFs is the absence of style drift compared with large core market equity funds where managers sometimes delve into smaller caps in an attempt to outperform the benchmark, or the herding of strategic bond funds into high yield last year.

Industry-wide however, ETFs can elicit a schizophrenic response from the wealth management industry. “I witness some hesitation from wealth managers to use a high portion of ETFs in portfolios through fear that clients may not think they are justifying their fees,” says Thomas Meyer zu Drewer, head of ComStage ETF.

“Wealth managers often reply that in order to charge a fee, they have to show that they have added value, and they say that if they use only ETFs, then the client may think that he could do that by himself,” he explains. “He’d be wrong of course, but that is not the issue.”

On the other hand, some wealth managers such as Alan Miller’s SCM private advisory firm are now focusing on ETF-only portfolios. Since March it has been offering a db X-trackers fund of ETFs with a TER of 0.89 per cent and additional trading costs of around 0.1-0.2 per cent, totalling 1.1 per cent, half the traditional multi asset FOF fund charge of 2-2.5 per cent.

Niamh Wylie, Coutts